Everything that deceives may be said to enchantCommentary on the News
Monday, May 30, 2011Ed DeShields

This week, the investment bank community seems to be enchanted with oil investments. Buy signals for oil usually come on optimism that economic growth is emerging thus stimulating more demand and profits. But, it’s different this time.

Interestingly, these same bankers are not optimistic about economic growth at all. They downgraded their economic growth projections betting growth will not be there. Could lower growth and higher oil prices be a signal of what’s ahead? Will anyone notice this head fake in the markets?

I bet you will when you see $5 gas later this year (according to a largely ignored Morgan Stanley forecast).

The most fundamental component that drives oil prices is economic growth. Growth causes more consumption and in turn drives prices up. The latest forecast, upped oil to $120/barrel for 2011 and $140/barrel for the end of 2012 on lower economic growth.

The world’s excess oil production capacity compared to demand is central to determining the price of oil: the smaller the supply buffer, the greater the risk of short-falls. Markets factor in the risk of short-falls through higher prices.

When a supply crunch forces oil prices beyond a certain point, the cost of oil forces consumers and businesses to cut other spending, inducing a recession. Recession destroys demand for oil, allowing prices to drop.

The world is entering an era defined by relatively short periods of economic growth terminating in oil price spikes and recession. This boom and bust cycle will be more the norm as oil demand vastly outstrips our ability to supply it.

Many expert analysts forecast that oil production capacity will fall or, at best, not grow as fast as demand in coming years. As a result, the supply buffer is diminishing and another supply crunch appears inevitable. The question is when.

The US Joint Forces Command forecasts that: “by 2012, surplus oil production capacity could entirely disappear, and as early as 2015, the shortfall in output could reach nearly 10 Mb/d.”

The UK Industry Task Force on Peak Oil and Energy Security predicts: “as early as 2012/2013 and no later than 2014/2015, oil prices are likely to spike, imperiling economic growth and causing economic dislocation.”

Lloyds of London says: “an oil crunch is likely in the short to medium term” and “appears likely around 2013.”

A German military report states: “some probability that peak oil will occur around the year 2010 and that the impact on security is expected to be felt 15 to 30 years later… [there will be] "partial or complete failure of markets… [including] shortages in the supply of vital goods could arise.. A restructuring of oil supplies will not be equally possible in all regions before the onset of peak oil.”

The IEA writes: “current global trends in energy supply and consumption are patently unsustainable…the era of cheap oil is over.”

New Zealand Parliament said, “in 2011, almost no new net capacity will be added and there will be a total net decline of about 0.7 Mb/d in capacity between 2011 and 2015. This means the maximum amount of oil that can be produced will begin to fall.” This is not due to lack of investment. It is because remaining oil reserves are becoming more difficult and costly to access. The average size of new discoveries is falling meaning more wells are needed to extract the same amount of oil. More footage of oil wells are being drilled than at any time since the early 1980s exploration boom (sparked by the 1970s oil shocks) and at greater cost but they are failing to find sufficient new oil to replace rapidly depleting production from existing wells.

The point at which the supply buffer is expected to disappear causing the next supply crunch is linked to economic growth. If the global economy rebounds strongly from this point (not likely), then oil demand will rise to hit maximum production capacity quickly (about 87 Mb/d). If the recovery is slower, or there is a double-dip recession, then it will take longer for rising demand to evaporate the supply buffer.

Here are some other interesting clues in the news:

The Kingdom of Saudi Arabia (KSA) recently began importing natural gas where it now must heat its heavier crude wells in order to recover it. Using energy to produce energy is a clear sign their cheap oil is dwindling.

Despite assurances of 12.5 Mb/d of total capacity, the KSA has not yet produced more than 9 Mb/d on a sustained basis in 2011.

The IEA is begging the KSA to pump more.

The KSA has turned to outside companies to help it begin to unlock heavy oil reserves that will take a lot of time, energy, and money to prosecute.

The KSA has a vastly expanded rig count as they expand drilling operations to produce more oil (odd behavior for a nation with an alleged 3.5 Mb/d of spare capacity?), then suddenly halted new drilling last July. The reason given was that the KSA was going to save their oil for their future citizens. I believe this was a deception. I believe KSA knows its supplies are limited.

The simplest and therefore most likely explanation for all of this is that the KSA does not actually have 12.5 Mb/d of total capacity, it is already at peak, and it's now struggling to maintain even 9 Mb/d of total output on a limited basis.

It’s a pretty good bet that Saudi Arabia is closer to Peak Oil than is currently being recognized by the world. And by financial markets know it. Why else would they issue buy recommendations on falling demand forecast. It doesn’t make sense.

The actions of the Saudis and their oil production data do not match their words. We should be watching to see a sustained production (more than a few months) well over the 9.5 Mb/d mark a change in this assessment. We could see it, but I seriously doubt it.

The reality of Peak Oil is that global growth will be facing permanent and serious headwinds from here. We’ll grow a little; then have it reversed by increased costs of energy in a repeating cycle.

We had better be prepared for the idea that our economic and financial systems will operate extremely poorly thereafter.